Why does the Fed get to manipulate the Economy?

Understanding the Fed’s Stabilization Policy

It’s been expected for weeks now that this month the Federal Reserve’s policy committee (the FOMC) will act to slow down the macroeconomy. High inflation rates of 7.0, 6.9 and 7.5 percent inflation in November, December and January, respectively, have made that an easy bet to make.

Over those same months the unemployment rate for the U.S. economy has been 4.2, 3.9 and 4.0—a sequence of rates that is also historic. Unemployment rates consistently at 4.0 or just below have only occurred twice in the last 25 years, in late 2000 and in late 2019. (Check out the bls.gov for more on the unemployment rate.) Recent data for February 2022, too, point to a very “robust” labor market.

Indeed, this past Wednesday Fed Chairman, Jerome Powell, told Congress what everyone has been expecting: the Fed will raise its target interest rate, and will do so in spite of the uncertainty for the global economy resulting from Russia’s attack on Ukraine.

For the non-macroeconomist, this likely begs the question: Why does the Fed have this power?

Who made the Fed boss?

The Fed has this power because Congress gave it to them. The Fed is charged with carrying out “Stabilization Policy”—the policy of the federal government to (attempt to) manage the business cycle. This is a mandate, in fact, legislated by Congress, first in 1946 with the Employment Act, and then reaffirmed and updated in 1978 with the Humphrey-Hawkins Act. Jerome Powell spoke with Congress this week as part of that responsibility.

What does it mean, then, to “manage the business cycle?” Consider this crudely drawn picture of the business cycle:

The business cycle is defined by the peaks (the high point of a boom) and the troughs (the low point of a recession). As shown in the figure, I assume that 2 percent is the “long run” growth rate of real GDP—a rate consistent with the last twenty or so years and with the current forecast of Potential GDP. The “business cycle” is the irregular oscillations of the macroeconomy around that long run value. When we reach a peak, the output gap is at its most positive; when we reach the trough, the output gap is at its most negative. (I explain the output gap here.)

The Fed’s job, as part of its mandate to carry out stabilization policy, is to temper this cycle. The Fed wants to avoid high-highs and low-lows. For example, consider the first peak in the picture. Let’s say that represents a recent and historically high business cycle peak for our economy. Further assume that at this peak the inflation rate is also running at historically high values and the unemployment rate is at historically low values.

Facing this scenario, the Fed needs to temper that peak—and when I say “temper” I mean kill it, squash it, flatten it out. As once said by former Federal Reserve chairman, William McChesney Martin, the Fed’s job is “to take away the punch bowl just as the party gets going.”

(Martin was the head of the Fed from 1951 through 1969, and obviously lived in a time when people went to parties that had punch bowls.)

Why is the Fed such a killjoy? Because when the business cycle reaches such a peak, the stability of the macroeconomy deteriorates—inflation surges and apprehension about the future seems to heighten (as reflected in various surveys, news stories, etc). From that precarious peak, it is inevitable that the economy will converge back to the long run growth rate (“revert to the mean”). And, as is often the case, the economy will not only converge back to the average growth rate, but it will keep on falling below that long run growth rate, resulting in a recession.

In fact, that a peak will be followed by a decline in real GDP will happen whether the Fed does anything or not. That is the nature of the business cycle. The Fed, therefore, tries to “stabilize” this process. In doing so, the Fed seeks to “execute a soft-landing.” That means to gently ease the economy off of that precarious and unstable peak; to cool things down so that that the growth rate converges back to the long run rate of 2.0 percent “nice and easy.” If successful, the conventional wisdom goes, the Fed can steer the economy away from going into a recession.

Moreover, if the Fed is doing their job right, the first peak we see in my figure above should not happen. Real GDP should not get that far above the long run trend, since doing so implies high rates of inflation, which is contrary to the Fed’s mandate. The Fed seeks a stable mix of a healthy labor market (the unemployment rate between 4 and 5 percent), and an inflation rate close to 2 percent.

The Fed would prefer, in fact, a lower peak, like the second one shown in the figure. A “calmer” expansion means there will be a lower peak, but it also means inflation should stay under control (unlike recently) and the unemployment rate should be within the range I just cited.

Et tu, Fed?

Based on this logic, a reasonable argument can be made that in 2021 the Fed “dropped the ball.” They had one job, and they didn’t do it. They could have slowed the economy starting this past summer, heading off what were already clear indications that inflation was picking up. But they didn’t. They continued to be “expansionary,” keeping their target interest rate near zero and continuing to purchase assets as part of their quantitative easing program (flooding the economy with liquidity, more or less). In other words, they continued to stimulate an already extremely stimulated macroeconomy.

In that view, the Fed has failed at their most important job, to stabilize the business cycle. Successfully carrying out stabilization policy means that rates of inflation of 7.0 percent should not happen.

Of course, hindsight is 20/20 and it’s easy to second-guess from the comfortable position of writing a blog. Why didn’t the Fed act sooner? Because the members of the Fed’s policy committee do not want to cause job loss if they do not have to. Hence, they are cautious and naturally take a “wait and see” approach to macroeconomic developments. It is reasonable to expect, too, that amidst a historically anomalous pandemic, the members of the policy committee would be especially locked into a “wait and see” approach.

Regardless of the “woulda-shoulda” arguments, the Fed is now ready to act. As stated by Jerome Powell this week, the Fed will raise it’s target interest rate when they meet in a couple of weeks. Why is the interest rate the key variable the Fed uses for “business cycle management?” The answer to that is somewhat involved. Hence, I’ll save the discussion on “why the interest rate?” for a follow-on blog post.

To close this post, I would be remiss not to address the attack on Ukraine by Russia. This sort of event, with far-reaching implications, adds an additional degree of difficulty for the Fed. They have to judge how these events may or may not change their opinion of macroeconomic conditions in the United States. Of course, that may seem like a crass concern during a week like the one the people of Ukraine have had. But, the Fed has a job to do. If the Fed thinks these events will send real GDP into a tailspin, then they will have to reassess whether or not “taking away the punch bowl” in 2022 will be the right move after all.